The Basics of Capital Budgeting
Should we
build this
Plant or rent
this plant?
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What is capital budgeting?
Definition: Capital budgeting, which is also called investment
appraisal, is the planning process used to determine whether
an organization’s long term investments, major capital, or
expenditures are worth pursuing or not.
◼ Analysis of potential additions to fixed assets (e.g., net gains
from investing in fixed assets).
◼ Long-term decisions; involve large expenditures (e.g.,
investing in machinery, establishing a plant, purchasing land
for companies, etc).
◼ Very important to firm’s future growth.
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Goals of capital budgeting
◼ Basically, the goals of budgeting is to provide a forecast of
revenues and expenditures and construct a model of how
business might perform financially.
◼ Capital Budgeting is most involved in ranking projects and
raising funds when long-term investment is taken into
account.
◼ Capital budgeting is an important task as large sums of
money are involved and a long-term investment, once
made, can not be reversed without significant loss of
invested capital.
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What is the difference between independent and
mutually exclusive projects?
◼ Independent projects – if the cash flows of
one are unaffected by the acceptance of the
other.
◼ Mutually exclusive projects – if the cash
flows of one can be adversely impacted by
the acceptance of the other.
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Techniques use in Capital Budgeting
To rank project in order to the importance and cashflow,
following techniques are used:
➢ Payback period
➢ Net Present Value (NPV)
➢ Internal Rate of Return (IRR)
➢ Profitability Index (PI)
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Payback Period
The payback period method is a method of evaluating a project by
measuring the time it takes to recover the initial investment.
Calculating the Payback Period
Simply, to calculate payback period: Payback Period = Amount to
be initially invested / Estimated Annual Net Cash Inflow.
(e.g., if you invest $10,000 for 6 years in project and earns $2,500/year, payback
period = $10000/$2500 = 4 years)
The example is for even cash inflows until the project duration.
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Payback Period - continued
But if the cash inflows uneven, then
ABC company investment of $200,000 is expected to generate the following cash inflows in six years:
Year 1: $70,000
Year 2: $60,000
Year 3: $55,000
Year 4: $40,000
Year 5: $30,000
Year 6: $25,000
Required: Compute payback period of the investment. Should the investment be made if management
wants to recover the initial investment in 4 years or less?
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Payback Period - continued
Solution: Initial investment = $200,000
Year cash inflow Cumulative cash inflow
1 70000 70000
2 60000 130000
3 55000 185000
4 40000 225000
5 30000 255000
6 25000 280000
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Payback Period - continued
Decision criteria
For independent project
Rank the projects in order to the payback period and decision to be made
accordingly.
For mutually exclusive projects
Lower the payback period, the project should accepted and vice versa.
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Payback Period - continued
Advantages and disadvantages of payback method:
Some advantages and disadvantages of payback method are given below:
Advantages:
• Payback period, as a tool of analysis, is often used because it is easy to apply and easy
to understand for most individuals, regardless of academic training or field of
endeavor.
• The payback period is an effective measure of investment risk. It is widely used when
liquidity is an important criteria to choose a project.
• Payback period method is suitable for projects of small investments. It not worth
spending much time and effort in sophisticated economic analysis in such projects.
Disadvantages:
• Payback ignores the time value of money.
• Payback ignores cash flows beyond the payback period, thereby ignoring the ”
profitability ” of a project.
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Discounted Payback Period
Example (if r = 10):
Year cash inflow Discounted cash Cumulative cash
inflow inflow
1 70000 70000/1.1 =
2 60000
3 55000
4 40000
5 30000
6 25000
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Net Present Value (NPV)
Net Present Value (NPV):
NPV can be described as the “difference amount” between the sums of
discounted cash inflows and cash outflows; or imply the difference between
PV of cash inflows and PV of cash outflows. The higher the NPV, the more
attractive the investment proposal. NPV is a central tool in discounted cash
flow (DCF) analysis and is a standard method for using the time value of
money to appraise long-term projects.
Therefore, the formula for NPV can be written in this way:
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Net Present Value (NPV) - Continued
Estimate NPV for project A and project B, if the discount rate
= 10%
Year Cash flow (A) Cash flow (B)
0 ($200,000) ($200,000)
1 $70,000 $55,000
2 $60,000 ($30,000_
3 $55,000 $40,000
4 $40,000 $55,000
5 $30,000 $60,000
6 $25,000 $70,000
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Decision criteria
• For mutually exclusive projects, higher the NPV the
project should be accepted and vice versa.
• For individual projects, rank the project and the highest
NPV project/projects should be accepted/management
decision in this regard is considered.
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